Treating intangibles as an investment in GDP – and next steps

The advanced estimate of GDP for the 2nd quarter of 2013 is out — and it surprise everyone by showing a 1.7% growth rate. Economist had expected the growth rate to be less that 1% (as was noted yesterday in the New York Times and the Wall Street Journal). Revisions to previous data also showed the economy was stronger that we thought.
The big news, from our perspective however, is the changes to the way GDP is calculated. There are a number of technical fixes (e.g. how pensions are accounted for) also being applied. But the most important is the treatment of spending on two intangibles: R&D and “creative works” — which will be treated as an investment rather than an immediate expense (see earlier posting). This means that for purposes of calculating the size of the economy, this spending will be depreciated over a number of years just like spending on plant and equipment. As BEA explains:

Expenditures by business, government, and nonprofit institutions serving households (NPISH)for research and development (R&D) are recognized as fixed investment. The new treatment improves BEA’s measures of fixed investment and allows users to better measure the effects of innovation and intangible assets on the economy.
Similarly, expenditures by private enterprises for the creation of entertainment, literary, and artistic originals are recognized as fixed investment, further expanding BEA’s measures of intangible assets.

(For more background, see the BEA article “Toward Better Measurement of Innovation and Intangibles
Peter Coy sums up the change in his BusinessWeek article “The Rise of the Intangible Economy”:

Steering a $16 trillion economy with the aid of historical GDP data is like driving a car while looking in the rearview mirror. But if that’s what policymakers must do–and it is–they need to make sure that the view to the rear is as clear as possible. That’s the purpose of recognizing R&D and artistic originals as investments, and bringing the national accounts more closely in line with the way the economy works and businesspeople think. Is it perfect? No. But better to be imprecisely correct than precisely incorrect.

With companies now spending more on intangibles than tangibles and with intangible assets making up most of the value of companies, it only make sense that we start treating intangibles as the investment they are. As Federal Reserve Board Chairman Ben Bernanke noted at a May 2011 Athena Alliance event, “We will be more likely to promote innovative activity if we are able to measure it more effectively and document its role in economic growth.”
Much of the press attention has been on the creative works part of the equation (see “Seinfeld Bests Kardashians as U.S. Recalculates GDP” on Bloomberg and “Getting creative with the GDP” in the New York Times). But the more important part is the treatment of R&D as an investment. This has two important aspects. One is that more data on R&D will be included, specifically as BEA notes, “a new category of investment, ‘intellectual property products,’ consists of research and development; entertainment, literary, and artistic originals; and software.” (This category grew by 3.8% in the last quarter.) The other is the change in mindset. BEA has actually been calculating GDP treating R&D as an investment for some time in a so-called “satellite” account. Now this recognition of R&D as an investment has gone mainstream.
Next steps
Recognition that R&D is an investment is mainstream in macro-economic, that is. There is, however, another data driven profession that still refused to count R&D as an investment: accounting. And those U.S. accounting rules may be creating a barrier to and distorting company R&D activities.
Under U.S. Generally Accepted Accounting Practices (GAAP), company research and development expenditures are considered expenses. They are treated as day to day operating costs, similar to workers’ wages or the electricity bill. As such, when it comes time to calculate the company’s profit, these expenses are subtracted directly from the bottom line. The higher the spending on R&D, the lower the profit.
However, if you allow for R&D spending to be treated as an investment (as now with GDP), then costs are apportioned over a number of years. Known as capitalization as it treats the spending as a form of capital improvement rather than an immediate cost. As a result, the immediate expense is lower and profits are recorded as higher.
To complicate matters, internal R&D spending is treated differently than R&D acquired from outside. If a company spends $1 million to develop a new technology, that is counted as an immediate expense. If a company spends $1 million to buy another company to acquire that technology, it is counted as an investment and must be capitalized. From an accounting point of view, this process may make sense because an internal expense is different from an acquisition. However, from an operating perspective, this difference between R&D expensing and R&D capitalization can be profound.
There are two possible problems: a decrease in R&D spending (a “lock up” effect) and a distortion of R&D spending toward acquisition versus internal R&D (the “balance” issue). The lock-up effect occurs when a company is hesitant to spend funds on R&D for fear of lowering reported profit — and thereby having a negative impact on shareholder value. The case of the stock market’s reaction to the divergent paths of Pfizer and Merck is a illustration of how increased R&D can be viewed by investors as a negative. This effect may be more pronounced for the small to medium sized (mid-capitalized) companies where stock analysts may not have the time to dig far beyond the profit and loss statements.
The balance issue affects where R&D takes place and who is making the research decisions. If acquired R&D is treated more favorable from a shareholder’s perceptive, there may be incentives created for existing companies to acquire technology from outside the company rather than development the technology in-house. Because of that incentive, the decision (consciously or unconsciously) regarding to what research is undertaken may not be made on the nature of the research but rather by who does it. For example, a company may decide not to pursue a certain line of research because it would have to be done in-house. Instead the company may wait to see what is developed externally and then seek to acquire that technology.
The balance issue may also impact the financial situation of startup companies. Startups are not well capitalized and are not in the position to acquire R&D from others. While startups may have access to R&D from universities and other public-private platforms funded by R&D activities flowing from the government or corporations, it is typical that a new, small business is creating their own R&D internally. As a result of the accounting rules, the smaller company which is reliant on internal R&D may be disadvantaged in the capital markets because of an appearance of lower profitability.
All of this has serious implications for the interaction between startups and existing companies — and the dynamics of the innovation process. Ideally, research decisions should not be biased one way or the other; the rules should be balanced or neutral between internal and external R&D. If a bias is to exist, there should be a solid public policy reason for that externally imposed bias. There may be good policy reasons to encourage the start-up/acquisition model of R&D over the in-house R&D model. But the possible existing bias toward acquisition due to the account rules exists because of historical circumstances, not a deliberate policy choice.
It is time to look more carefully at this issue to see whether the way in which account rules treat R&D (and intangibles in general) have become an impediment to innovation. And we need to ask a fundamental question: if we can treat research as an investment in our national accounts, why can’t we do the same in our company accounts?

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